Managing Downstream And Upstream Risks

Even the strongest, most sophisticated contractor has probably taken a lump or two over the past year as a result of one of the worst stretches the construction industry has seen in decades. Because of these challenges, there are many ways that you should be examining your own company, your cash flow needs, profit estimate and balance sheet projections.

Managing both your upstream risks and downstream risks will be critical to your success in the coming years. Ask the following questions:

How much bad debt can my company absorb before having a critical impact on my balance sheet and cash flows?

How long should I perform work without being paid? What does my contract allow for in terms of work stoppages for non-payment?

Who bears the risk of non-payment by the ultimate project owner? Do I have any “Pay If Paid” contracts?

How is this private project being financed? Has anyone seen a bank commitment letter?

What would happen if my receivables were stretched another 30-45 days on average?

How would this job be impacted if one of my subcontractors could no longer perform their work (due to bankruptcy or otherwise)? How much would it cost me to replace them?

What is my added exposure when I bond a job?

How do I address onerous contract terms with my owner/GC/client?

How do I know if my subcontractors are still financially viable?

There are landmines at every turn so be sure to not discount the value of doing your homework before signing a contract. What are some specific areas of risk to pay close attention to?

Upstream Risks

We all understand the inherent risks with subcontracting a portion of “your work” to another contractor for whom you will be responsible. How many of us though give a lot of thought to upstream risk? Are you a sub to a general contractor? Sub to another sub? Vendor, supplier? Or a general contractor doing work for a private company? All of these scenarios carry several risks.

The most obvious upstream risk is no pay/slow pay from your client. As a general contractor doing work for a private owner, you will typically have the ability prior to starting the work to inquire about project financing. Do not dismiss this right and take full advantage of this opportunity as you will likely have difficulty getting anything else from the owner once the project has begun. Useful tools here include a “set aside” letter from their bank, loan commitment letter for project specific funding or a bank reference letter stating that the owner has sufficient cash on hand to pay for the project.

Even if you are not prime to an owner, all of these risk factors affect you. Unfortunately, you will not likely have access to your upstream contractor’s financials and will be somewhat dependent on their due diligence with the owner. Even so, don’t be afraid to ask your prime contractor (or upstream contractor) if they have done their homework. Also, check with your peers or any subs/suppliers who are working for your general contractor to see how timely they are currently making payments.

Downstream Risk

If you are a general contractor, part of your normal operating procedure is to monitor subcontractor bids and hopefully that includes a formal prequalification process for the majority of your subs. The amount of data you request is up to you, but the following is a key list of things you should know about your potential subcontractors:

What is their reputation? Do they have reference letters? How many jobs of similar size and scope have they performed in the past?

What is their safety history? Do they have a dedicated safety director?

What is their financial status? Have they ever failed to complete a job? Will they share financials?

Do they have a bond company and/or a bond line? If so, what are their single and aggregate limits? Can you obtain a letter from their surety stating these limits and current capacity?

Do they have all the required insurance currently in place? How do you monitor and track expiring certificates throughout the year?

Do you know how many subs or suppliers they will engage to fulfill the contract? If you are providing a bond as a prime contractor, these parties will all be covered by your Payment Bond and add to your potential exposure for non-payment claims.

This economy has certainly taken its toll on a large number of contractors. Often the smaller, trade contractors are hit the hardest as they did not carry large backlogs of work or large balance sheets into this downturn. They could be dependent on their next job for their very survival so it is critical that all parties are aware of potential risk factors with key subs and suppliers and employ as many additional tools as possible to mitigate those risks and prevent another contractor’s problem from being your problem.